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Capital Budgeting

Capital Budgeting. Chapter 13. Capital Budgeting. The process of planning investments in assets whose cash flows are expected to extend beyond one year. Importance of Capital Budgeting. Long term impact Timing

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Capital Budgeting

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  1. Capital Budgeting Chapter 13

  2. Capital Budgeting • The process of planning investments in assets whose cash flows are expected to extend beyond one year

  3. Importance of Capital Budgeting • Long term impact • Timing • Substantial expenditures for which funds must be raised (either internally, externally, or both)

  4. Project Classifications • Replacement decisions • decisions to determine whether to purchase capital assets to take the place of existing assets to maintain existing operations

  5. Project Classifications • Expansion decisions • decisions to determine whether to purchase capital projects and add them to existing assets to increase existing operations

  6. Project Classifications • Independent projects • projects whose cash flows are not affected by the acceptance or rejection of other projects

  7. Project Classifications • Mutually exclusive projects • a set of projects where the acceptance of one project means the others cannot be accepted

  8. Steps in the Valuation Process • 1. Determine the cost, or purchase price, of the asset • 2. Estimate the cash flows expected from the asset • 3. Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows • 4. Compute the present value of the expected cash flows • 5. Compare the present value of the expected cash inflows with the initial investment, or cost, required to acquire the asset

  9. Cash Flow Estimation • Cash is different from accounting profits • Count cash flows after taxes • Only incremental cash flows are relevant to the accept/reject decision • the change in a firm’s net cash flow attributable to an investment project

  10. Problems in Cash Flow Estimation • 1. Sunk costs • already incurred and cannot be recovered • 2. Opportunity costs • return on the best alternative use of an asset • 3. Externalities • the effect accepting a project will have on the cash flows in other areas of the firm

  11. Problems in Cash Flow Estimation • 4. Shipping and Installation • the depreciable basis for an asset includes the purchase price plus shipping and installation • 5. Depreciation • depreciation is a non-cash expense affecting taxable income, thus taxes • 6. Inflation • expected inflation should be built into the expected cash flows

  12. Identifying Incremental (Relevant) Cash Flows • Cash flows that occur only at the start of the project’s life • Cash flows that continue throughout a project’s life • Cash flows that occur only at the end, or termination of the project

  13. Identifying Incremental (Relevant) Cash Flows • Initial investment outlay • includes the incremental cash flows associated with a project that occur only at the start of a project’s life, CF0 ^

  14. Identifying Incremental (Relevant) Cash Flows • Incremental operating cash flow • changes in day-to-day cash flows that result from the purchase of a capital project and continue until the firm disposes of the asset

  15. Incremental Operating Cash Flow

  16. Identifying Incremental (Relevant) Cash Flows • Terminal cash flow • the net cash flow that occurs at the end of the life of a project, including the cash flows associated with: • 1. final disposal of the project • 2. returning the firm’s operations to where they were before the project was accepted

  17. Cash Flow Estimation and the Evaluation Process • Expansion projects • initial investment outlays required • estimate the cash flows once production begins • terminal cash flow

  18. Cash Flow Estimation and the Evaluation Process • Replacement analysis • must consider cash flow from old asset and new asset in decision • cash flows from the new asset take the place of cash flows from the old asset

  19. Capital Budgeting Evaluation Techniques • 1. Payback • 2. Net present value (NPV) • 3. Internal rate of return (IRR)

  20. Payback • Payback period is the length of time before the original cost of an investment is recovered from the expected cash flows

  21. Net Present Value • NPV is a method of evaluating capital investment proposals by finding the present value of future net cash flows, discounted at the rate of return required by the firm • One of two discounted cash flow (DCF) techniques using time value of money that we will cover

  22. Net Present Value

  23. Discounted Payback • Discounted payback is the length of time it takes for a project’s discounted cash flows to repay the initial cost of the investment

  24. Internal Rate of Return • IRR is the discount rate that forces the PV of a project’s expected cash flows to equal its initial cost • Similar to the YTM on a bond

  25. Comparison of the NPV and IRR Methods • NPV profile is a graph (curve) showing the relationship between a project’s NPV and various discount rates (required rates of return) • IRR is at the point where the NPV profile crosses the X axis

  26. NPVs and the Required Rate of Return • Crossover rate • the discount rate at which the NPV profiles of two projects cross and, thus, at which the project’s NPVs are equal

  27. Independent Projects • NPV and IRR will both lead to the same decision • if a project’s NPV is positive, its IRR will exceed k, while if NPV is negative, k will exceed the IRR

  28. Mutually Exclusive Projects • If NPV profiles cross, NPV and IRR decisions may conflict depending on discount rate selected • project size differences • timing differences • reinvestment rate may not match IRR • NPV method is preferred

  29. Multiple IRRs • A project can have two or more IRRs • unconventional cash flow pattern • large outflow during or at the end of its life • NPV profile is required

  30. Conclusions on the Capital Budgeting Decision Methods • Payback and discounted payback indicate risk and liquidity of a project • NPV gives a direct measure of the dollar benefit to the shareholders • IRR provides information about a project’s “safety margin” • IRR reinvestment assumption may be unrealistic • Watch out for multiple IRRs

  31. Incorporating Risk in Capital Budgeting Analysis • Stand-alone risk • the risk an asset would have if it were a firm’s only asset • measured by the variability of the asset’s expected returns

  32. Incorporating Risk in Capital Budgeting Analysis • Scenario analysis • a risk analysis technique in which “good” and “bad” sets of financial circumstances are compared with a most likely, or best-case situation

  33. Incorporating Risk in Capital Budgeting Analysis • Worst-case scenario • an analysis in which all of the input variables are set at their worst reasonably forecasted values

  34. Incorporating Risk in Capital Budgeting Analysis • Best-case scenario • an analysis in which all of the input variables are set at their best reasonably forecasted values

  35. Incorporating Risk in Capital Budgeting Analysis • Base case • an analysis in which all of the input variables are set at their most likely values

  36. Incorporating Risk in Capital Budgeting Analysis • Corporate (within-firm) risk • risk not considering the effects of stockholders’ diversification • measured by a project’s effect on the firm’s earnings variability

  37. Incorporating Risk in Capital Budgeting Analysis • Beta (market) risk • that part of a project’s risk that cannot be eliminated by diversification • measured by the project’s beta coefficient

  38. Corporate (Within-Firm) Risk • Diversification (risk reduction) • as long as assets are not perfectly positively correlated some diversification can be achieved • adding projects can help reduce corporate risk

  39. Beta (or Market) Risk • Project required rate of return, kproj • the risk adjusted required rate of return for an individual project • kproj = kRF + (kM - kRF)proj

  40. Beta (or Market) Risk • Pure play method • estimating beta of a project using firms whose only business is the product in question to approximate its own project’s beta

  41. How Project Risk is Considered in Capital Budgeting Decisions • Risk-adjusted discount rate • required rate of return that applies to a particularly risky stream of income • equal to the risk-free rate of interest plus a risk premium appropriate for the level of risk attached to a particular project’s income stream

  42. Capital Rationing • A situation in which a constraint is placed on the total size of the firm’s capital investment

  43. Multinational Capital Budgeting • Repatriation of earnings • process of sending cash flows from a foreign subsidiary back to the parent company

  44. Multinational Capital Budgeting • Exchange rate risk • uncertainty associated with the price at which the currency from one country can be converted into the currency of another country

  45. Multinational Capital Budgeting • Political risk • the risk of expropriation of a foreign subsidiary’s assets by the host country, or of unanticipated restrictions on cash flows to the parent company

  46. End of Chapter 13 Capital Budgeting

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